Posted tagged ‘Privilege’

Cleaning Up After The Elephants – A Practical Reminder On Document Preservation Policies and Litigation Holds In Tax Disputes

September 2, 2013

By Phil Karter

Any corporate tax executive who has ever been involved in contesting an audit adjustment knows all too well how unfavorable documents relating to the subject of the adjustment – particularly improvident comments reflected in email correspondences – can be an ongoing impediment to resolving a tax dispute from the audit phase right up to and through litigation with the IRS or Department of Justice.  When such documents exist, even where taken out of context, the government will zealously sink its teeth into them like a junkyard dog, making the prospects of reaching a reasonable settlement or gaining an IRS concession all the more difficult.  One can’t fault the government for taking a hardline position.  Precedent reflects that this is a good strategy, particularly in economic substance cases, as demonstrated by the numerous times these unfavorable documents work their way into the text of court opinions as the factual underpinning for an adverse finding against the taxpayer.  Like a Dickensian character, they will come back to haunt you again and again.

The solution, of course (conveniently ignoring the practical realities of many understaffed and overburdened tax departments), is for the tax function to do a better job of policing both document production and retention policies, particularly outside of its own direct jurisdiction and normal supervision.  Non-tax business justifications pervade so many tax disputes that it is incumbent on the tax executives to ensure that these justifications are not only well-documented, but consistently followed in practice after the transaction is put into place.  The tax folks are, after all, the ones ultimately on the front lines defending the non-tax business justification.  As they say, it’s like cleaning up after the elephants in the circus parade – unpleasant but necessary.

In the course of this process, it is important to remain mindful that once documents are created, particularly in connection with a transaction where future litigation may reasonably be anticipated, a duty to preserve via a litigation hold may override a company’s normal document destruction policies.  See e.g., Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir.2001)  (duty to preserve evidence “arises not only during litigation but also extends to the period before the litigation when a party reasonably should know that the evidence may be relevant to anticipated litigation.”)  Indeed, the failure to put a litigation hold in place can have deleterious consequences, from waiver of attorney work product protection (see e.g., Samsung Electronics Co., Ltd.. v. Rambus, Inc., 439 F. Supp. 2d 525 (ED Va. 2006) (rev’d on other grounds, 523 F.3d. 1374 (Fed. Cir. 2008)), to IRS challenges regarding the completeness of a taxpayer’s Schedule UTP disclosures (which does not require reserves to be recorded for positions “expected to be litigated”), a topic I have written about before.  Simply put, it is difficult to persuasively argue that an issue was reasonably anticipated to be litigated (e.g., for work product protection or UTP purposes), where there is a failure to implement a litigation hold predicated on that very anticipation.

Earlier this month, U.S. District Judge Shira Scheindlin (S.D.N.Y.), author of the landmark Zubulake opinion on electronic discovery, raised the stakes further when she ruled, in Sekisui American Corp. v. Hart, 2013 WL 4116322 (S.D.N.Y. Aug. 15, 2013), that a party who failed to preserve electronically stored information (ESI) by not implementing an adequate litigation hold was subject to an adverse inference about the content of such evidence.  The ruling was notable because it bucked the trend of courts to overlook a party’s destruction of ESI in the normal course of its business practices, notwithstanding the obligation the party may have had to implement a litigation hold to preserve such documents.  (See Fed. R. Civ. P. 37(e), requiring “exceptional circumstances” to impose sanctions.)  In Sekisui, Judge Scheindlin imposed the adverse inference sanction (in addition to monetary damages) even without finding any malevolent intent or substantial prejudice to the opposing party.  The court simply ruled that the failure to implement a litigation hold was enough to constitute a willful intent to destroy documents.

It doesn’t take a great deal of imagination to appreciate that a ruling invoking an adverse influence as a result of the failure to preserve documents can be fatal, an even more likely outcome in a bench trial where the judge making the ruling is also the trier of fact.  At the very least, being slapped with such a sanction will preclude any benefit of the doubt that documents interpreted negatively by the IRS may be accorded a more favorable interpretation by the trier of fact.

I have heard – certainly more than once – government counsel advocate to a court words to the effect that “memories fade but documents never lie.”  It is true that the odds of prevailing in a tax dispute are not helped by poor recordkeeping practices, by which I include both shoddy documentation as well as carelessly policed documentation containing ill-conceived content readily subject to misinterpretation and misuse.

If nothing else, the ruling of an influential jurist like Judge Scheindlin should heighten tax departments’ sensitivities about monitoring company recordkeeping practices from the outset of a transaction.  These efforts should be quantitative in terms of fully apprehending the documents to be generated and maintained, and qualitative to reduce the risk that problematic documents are generated carelessly and maintained thoughtlessly.  No less thought should be put into the timely implementation of litigation holds to ensure that company records – hopefully those that will help it carry the day in a tax dispute – are adequately preserved, particularly when the ramifications of their destruction can exponentially increase the likelihood of an unfavorable outcome.

Musings in the Aftermath of the First Schedule UTP Filing Season

December 8, 2011

By Phil Karter

As reported earlier this week in the tax press, the recently completed initial filing season for Schedule UTP produced at least one major surprise in the eyes of IRS officials, who had anticipated a much greater number of items listed on the average Schedule UTP than actually materialized.  In fact, the IRS’s predictions were off by a wide margin, with the number of disclosed positions of the 1,500 or so Schedule UTPs filed averaging only slightly more than three items per schedule for CIC taxpayers, and less than two items for non-CIC taxpayers.  Pre-filing expectations of item disclosures had been many multiples higher, perhaps even reaching as high as 100 or more separately stated positions.  Although such predictions may have been wildly optimistic from the IRS’s standpoint, one must now wonder whether the apparent failure of the first filing season to meet the Service’s anticipated disclosure bonanza will hasten efforts to extend the penalty regime to specifically target what are viewed as incomplete or inadequate disclosures on Schedule UTP. (more…)

Protecting the Privilege: Practice Tips for Kovel Engagements

May 12, 2011

By Jonathan Prokup

With the IRS’s increasing emphasis on transfer pricing and other tax issues that depend upon economic and scientific concepts and analyses, tax attorneys frequently rely on non-legal professionals to provide expert assistance in areas with which an attorney might not be familiar.  While this non-legal expertise helps facilitate the attorney’s representation of her client, the introduction of these non-legal professionals into the attorney-client relationship poses an obvious concern about breaching the attorney-client privilege.  Ordinarily, if someone other than the attorney and the client is included in a communication, the attorney-client privilege is unavailable. (more…)

Squib Notes: Venerable “Kovel Rule” May Be Under New Attack

May 10, 2010

By Phil Karter

For almost 50 years, lawyers have relied on the “Kovel Rule” to extend the attorney-client privilege to non-testifying accountants or other business experts.   The philosophy behind the rule, so named after the landmark case, United States v. Kovel, 296 F. 2d 918 (2nd. Cir. 1961), is to recognize “the complexities of modern existence [which] prevent attorneys from effectively handling clients’ affairs without the help of others . . . .”  Id. at 921.  Without such a rule, disclosure to a third party would constitute a waiver of the attorney-client privilege.

In practice, the Kovel Rule has been ubiquitously employed by lawyers who engage other professionals to assist them in rendering render legal advice.  Most typically, the lawyer engages the third-party professional by means of a written engagement, known as “Kovel Agreement.”  Where the third-party is first contacted directly by the client rather than through the lawyer, a greater level of scrutiny about whether the privilege attaches typically ensues because of concern over whether the professional’s advice is really necessary for the lawyer to render legal advice.  For example, a previous relationship between a client and the third-party consultant, or a direct relationship, can be viewed as evidence the third-party is merely performing consulting work rather than facilitating the lawyer’s ability to render legal advice.  See e.g., In re G-I Holdings Inc. 218 F.R.D. 428 (D. N.J. 2003).

Kovel is not without its detractors, and courts have nibbled at its edges for years.  However, a recent comment by a senior IRS Chief Counsel attorney at last week’s ABA Tax Section meeting suggests a full frontal assault may be in the cards.  The official, Janet Johnson, Deputy Division Counsel for Criminal Tax, stated, “We will take the position that the accountant is independently working and not covered by privilege.” How the government intends to argue in favor of a blanket reversal of Kovel remains to be seen, but a word to the wise is that such arrangements should be carefully crafted and contemporaneously documented.  Once in place, due care should be taken to ensure that the formalities of the lawyer-consultant relationship are meticulously observed.  Clients, in turn, should have a clear understanding about the nature and purpose of Kovel relationships particularly in the event there is direct interaction with the third-party professional.  Lastly, when the third-party professional is an accountant, it is unclear how, if at all, the privilege for accountant-client communications, established in 1998 under Section 7525 of the Internal Revenue Code, would be implicated by the frontal assault contemplated by Ms. Johnson.   At this point, all we can say with certainty is stay tuned.

Trust but Verify – Proposed Schedule UTP and the Implications to Attorney Work Product

April 20, 2010

By Phil Karter

Last week, at the TEI Midyear Conference in Washington, LMSB Commissioner Heather Maloy told corporate tax executives attending the conference that “trust” was the key to successfully implementing the new reporting requirements for uncertain tax positions first set forth in Announcement 2010-9.  As reported in the April 14th edition of Tax Notes, 2010 TNT 71-2, Maloy also told the attendees that enhanced transparency through the use of this reporting mechanism would be “mutually beneficial” in terms of improved issue resolution and efficiency.

Last month, I commented on an aspect of Announcement 2010-9 that had received relatively little attention, namely the requirement that taxpayers must file the new disclosure form not only when recording a reserve in their financial statements, but also when expecting to litigate “uncertain tax positions” even if no reserves are recorded.  (For earlier commentary, click here.)  The concern I articulated was whether the failure to disclose a tax position for which no reserve was claimed would precipitate an attack on taxpayer claims of work product, which rely on an “anticipation of litigation” standard.

The proposed new Schedule UTP and its accompanying instructions, released in draft format yesterday, don’t help us much in forecasting an answer to this question.  A single example of the expectation to litigate is provided in the proposed instructions:

A corporation takes a position that it can exclude certain income from its 2010 tax return.  On September 30, 2010, the corporation determines that, if the IRS had full knowledge of the tax position, there is less than a 50% probability of settling the issue with the IRS.  The corporation also determines that, if the tax position were litigated, it has a 60% probability of prevailing in the litigation.  Based upon these determinations, the corporation did not record a reserve for the tax position.  Because the corporation made a decision not to record a reserve with respect to its 2010 tax position based on a determination, consistent with applicable accounting standards, that it will litigate, rather than settle, the issue with the IRS and that the corporation will prevail in the litigation, and because that decision was made more than 60 days before filing its 2010 tax return, the corporation must report this tax position on the Schedule UTP filed with its 2010 tax return.

On its face, the lesson from this example seems clear enough.  A taxpayer who concludes it has a more likely than not chance of winning an issue in litigation should recognize the entire tax benefit in its financial statements under FIN 48 and claim no reserve.

Nonetheless, the unlikelihood of settling an issue the taxpayer believes is better than a 50% bet means that litigation is a virtual certainty unless the dollars involved do not justify the litigation cost.  How can a taxpayer afford not to file Schedule UTP in that instance and still feel assured that any legal analysis of the issue retains its protected status as attorney work product?  The answer is that it can’t – at least not without clarification from the Service about whether and when an attack on work product claims will be raised if the Schedule is not filed (or a working assumption that work product protection may not attach).  Even that may not be enough.  In refund suits, litigation strategy is the province of the DOJ Tax Division.  Absent the public articulation of a coordinated and consistent policy of restraint over when and when not to dispute work product claims on the basis of a taxpayer’s failure to file Schedule UTP, taxpayers can take little comfort that they won’t wind up in a discovery dispute over legal analysis that has been traditionally the beneficiary of robust protection from disclosure.  Of course, that may all be part of the plan.  Nonetheless, the ability to “trust” the push toward greater disclosure may require the Service and DOJ to “verify” their ultimate intentions.

Finally, consider the circumstances where a taxpayer believes it is “spot-on” on an issue that has been litigated successfully by other taxpayers before, only to be challenged again, perhaps in another jurisdiction.  Such a case would not require the establishment of a reserve and the taxpayer may have had good reason to believe the issue would not be challenged or, if challenged, would likely be settled favorably.  Should a Schedule UTP be filed in that instance?  Arguably not, but how does a taxpayer prove it believed litigation was unlikely?  Such a circumstance is arguably a classic Catch-22.  On one hand, the taxpayer needs to document the basis for its analysis that litigation was unlikely to justify its decision not to file the schedule.  On the other hand, if the taxpayer’s prediction is wrong and the issue is disputed, it will be difficult to claim work product protection for the analysis because it is unlikely to satisfy the anticipation of litigation requirement.

The moral of the story is that a decision not to file Schedule UTP should be well documented, but with the working assumption that the legal analysis supporting the decision will likely be subject to disclosure if the matter ends up in litigation unless it fits under the umbrella of attorney-client privilege.

The Subliminal Message Underlying Announcement 2010-09

March 11, 2010

By Phil Karter

Predictably, there has been a good deal of consternation accompanying the release of IRS Announcement 2010-09, which continues the trend away from the Service’s traditional “policy of restraint” in seeking to uncover uncertain tax positions.  The first chink in this long-standing policy of restraint was exhibited in Announcement 2002-63, where the Service expanded the circumstances under which it would seek tax accrual workpapers.  Prior to the earlier Announcement, workpaper demands were limited to workpapers relating to listed transactions provided such transactions had been disclosed.  Thereafter, a taxpayer who engaged in more than one listed transaction, whether previously disclosed or not, was subject to a demand to disclose all workpapers.  The IRS’s summons enforcement action in Textron relied on Announcement 2002-63 to seek all of the taxpayer’s workpapers (arguing that six separate SILO transactions fit within the scope of its new policy).

Announcement 2010-09 goes significantly further in eroding the policy of restraint by placing the onus on the taxpayer to make its own affirmative disclosures of uncertain positions rather than requiring the Service to deduce them from the taxpayer’s workpapers.  What has received little attention, however, are the implications of the Service’s intention to require the new disclosure form not only for taxpayers who record a reserve in their financial statements for uncertain tax positions, but also taxpayers who “expect[] to litigate the position.”

(more…)


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